An Investor’s Overview of Speculating With Options

Options are contracts that give the holder the right — but not the obligation — to buy or sell an underlying stock at an agreed-upon price. It’s important to understand the particulars of the contract that define when the option may be exercised, the profitability bracket for the option, and more.

Speculating using options allows traders to gain long or short exposure to a stock without the need to fully invest in that stock. For example, instead of buying fully into a long position in a stock, a trader may instead purchase a call option on it. The price of an option takes several elements into account, including intrinsic value, extrinsic value, volatility, and more. However, this price generally costs a fraction of the cost of purchasing a long position in a stock.

This may allow advanced traders to speculate on price direction and volatility of a stock without investing as much money as owning the stock outright. Options can provide a way to gain leveraged exposure, albeit with different risk parameters, to a stock. Traders may do so through long and short calls and puts.

A call gives the buyer the right — but not the obligation — to purchase an underlying stock at an agreed-upon strike price. Calls are generally considered bullish, as they anticipate prices will increase. Should prices exceed the strike price, the buyer may exercise the call option. They would then receive the underlying stock at a lower strike price than the current price. Long calls are considered to have a lower risk for buyers. They only lose the cost of the premium paid if the option expires unused.

A put gives the buyer the right — but not the obligation — to sell a stock at an agreed strike price. Puts are generally bearish, as they anticipate prices declining. As with a long call, a long put’s profitability range should take into account the premium paid.

Short calls and puts mean a trader is selling or writing an option. While an option writer receives a premium, short calls and puts carry an elevated risk for the writer. A short call would only be profitable for the writer should the underlying stock price fail to rise to meet the strike price. The writer misses out on the market upside beyond the strike price if the short call is exercised. Similarly, a short put only proves profitable should prices fail to decline to the strike price. A short put writer would receive shares of the stock should the put be exercised by the corresponding owner. A short call writer would short the stock if the call is exercised by the owner.

Advanced, experienced option traders may combine calls and put in a variety of different strategies. While some seek to produce income, others seek to hedge against downside risk or reduce volatility. An options spread strategy entails buying calls or puts on the same stock but with different strike prices or expiration dates. Meanwhile, an option straddle buys a call and a put on a stock where both options have the same expiry and strike price. An option strangle strategy buys both a call and a put on the same stock with the same expiry but different strike prices. All have different use cases, different risk profiles, and different outcome expectations.

When speculating with options, it’s important to understand the differences between speculation and gambling. Speculating generally entails taking a calculated financial risk, even though the outcome remains unknown. It includes fundamental and technical analysis of an underlying asset, market conditions, and more. This analysis may include charting trends using simple moving averages, knowledge of upcoming events that may impact stock prices and volatility, and a number of other factors.

Conversely, gambling can involve betting money in a game of chance with an unknown outcome. It generally carries a higher probability of losing compared to winning, with odds that generally do not favor the gambler. Additionally, there may be no way to offset risks in gambling. Whereas, speculating involves analysis and may be less reliant on simple chance.

When using options to speculate, a number of tools exist to help traders limit their risk potential. First and foremost, having a detailed trading plan before investing in options and holding to it may help to reduce unpredictable outcomes. On the technical side, understanding the importance of position sizing may limit risk exposures. To curtail higher-risk option positions, traders may hold a smaller position size to limit their possible losses. Conversely, in more favorable appearing positions, they may hold a greater number of contracts in that position. It’s worth noting that each option contract covers 100 shares of a stock. Additionally, stop-loss orders allow a trader to set a limit on losses by setting a price at which they sell out of a position. They may also be used to protect unrealized gains.

Traders have several choices when seeking to speculate. By investing in options, they may gain leveraged exposure, but not ownership, to an underlying asset with a smaller capital pool than investing directly in the stock itself. Through careful analysis, traders may take a calculated risk when buying and selling option contracts.

Different options, contracts, and strategies offer different risk profiles that may enhance loss and profitability potential. Using any form of leverage carries enhanced risks for traders. Options provide flexibility in allowing traders to position for a number of potential outcomes and express their views on market and underlying stock directionality, volatility, and more. When using options to speculate and for leveraged exposure to underlying stocks, it’s important that traders also engage in risk management practices.

Buying on margin is another way traders may gain leveraged exposure to a stock. When buying on margin for a stock, an investor obtains a loan from their brokerage to purchase stocks. This allows them to gain access to a larger position with less capital than buying stocks outright. While it has the potential to yield larger returns, it also amplifies the loss potential. Buying on margin magnifies the risk for traders.

An option margin differs from buying a stock on margin. While the latter involves leveraging a position, an option margin refers to the collateral a trader must provide before selling options. Investors may generally deposit either securities or cash into their account to satisfy margin requirements. Different brokers may have different margin requirements, and option traders must be aware of these before entering a trade. Because option writers often have part of their capital tied up in the collateral, it introduces an added layer of risk and leverage. What’s more, options-writing strategies with multiple positions may require meeting multiple differing option margin requirements.

Any type of leverage adds an additional element of risk, including options. Leverage often amplifies the potential gains and losses, sometimes exponentially, for investors. It’s important for investors to use risk management practices when creating and enacting an investment plan.

Options can bring flexibility and provide a powerful tool for traders to speculate on stocks and market moves. Options trading requires an extensive amount of knowledge and trading experience. And that’s given the heightened risk potential compared to investing directly in stocks or bonds. While options can magnify the return potential of an investment, they also amplify potential losses. By taking calculated risks and engaging in risk management practices, options investors may seek to profit from and capitalize on a wider range of market environments than direct stock and bond investors.

Before making any trades, it’s crucial to further your options trading education. Resources like the BMO InvestorLine Learning Centre offer valuable information and tools to help you get started.

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